An Upcoming Debate on Whether Private Equity Should Pay Higher Taxes

If you are looking for a break from the dreary debate over the budget, our friends at Tax Analysts will be holding a roundtable discussion on Friday afternoon on the tax treatment of private equity firms. The issue has generated lots of interest since the First Circuit Court of Appeals ruled that a private equity firm was engaged in a “trade or business” under ERISA, the federal pension law.

If the court’s decision is extended to tax law, these firms and their investors could face significantly higher taxes than they do today. .

My Tax Policy Center colleague Steve Rosenthal has argued the ruling, in a case called Sun Capital Partners v. New England Teamsters & Trucking, could result in a private equity fund being treated as an operating business rather than a passive investor. If Steve is right, returns to the firm’s managers could be taxed as ordinary income, rather than at lower capital gains rates. In addition, tax-exempt and foreign investors could be subject to U.S. tax on their returns. Steve has urged Treasury to write regulations to clarify these rules.

Interestingly, while Congress continues to debate whether the compensation of private equity managers, aka carried interest, should be taxed at higher rates, the reasoning in this case could open the door for higher taxes under current law, without the need for new legislation.

A key question: Do private equity firms such as Sun Capital merely act as investors or do they manage the businesses they acquire in order to boost their profits. The firms make the legal argument that they only invest, but their promotional materials often claim that they aggressively intervene in the management of underperforming companies before flipping them at a profit.